Question

13. NPV versus IRR Consider the following cash flows on two mutually exclusive projects for the Bahamas Recreation Corporation. Both projects require an annual return of 15 percent.

YEAR	DEEPWATER FISHING	NEW SUBMARINE RIDE
0	−$835,000	−$1,650,000
1	450,000	1,050,000
2	410,000	675,000
3	335,000	520,000

As a financial analyst for the company, you are asked the following questions.

1. If your decision rule is to accept the project with the greater IRR, which project should you choose?
2. Since you are fully aware of the IRR rule’s scale problem, you calculate the incremental IRR for the cash flows. Based on your computation, which project should you choose?
3. To be prudent, you compute the NPV for both projects. Which project should you choose? Is it consistent with the incremental IRR rule?

Answer 1

a. Let us first calculate the IRR for the two projects ,

Deep water fishing :

CF0 = ($835,000)

CF1= $450,000

CF2= $410,000

CF3= $335,000

So, the IRR of this project is :

IRR = 21.49%

B. The incremental IRR can be calculated by subtracting the cash flows of the smaller project from the larger project. So, the incremental IRR is :

CF0 = ($815,000)

CF1 = $6,00,000

CF2 = $265,000

CF3= $185,000

So, the IRR is :

Similarly, the IRR for New submarine ride is ,

IRR = 19.76%

So, as per the IRR rule, the project with the higher IRR should be chosen. So, project Deepwater fishing should be chosen.

Incremental IRR = 17.6543%

So, as the IRR > Cost of capital the larger project should be chosen. We should choose the New submarine ride.

The NPV of the project is :

= ($835,000) + $450,000/1.15 + $410,000/1.15^2 + $335,000/1.15^3

= $86,591.1893

Similarly, the NPV for New submarine ride is :

= $115,348.8946

So, as per the NPV rule, the project with the higher NPV should be chosen and that is project New submarine ride. Yes, it is consistent with the Incremental IRR rule.